by John C. Marchisi (former U.S. Stock Exchange Official)
There has been a certain buzz on the street revolving around possible new regulation shortly coming into effect, regarding the need for improved transparency within the capital markets. Unfortunately, I fear the perception as to there is such a need for change has missed the mark once again.
Transparency has been the keyword and focus within the scope of recent efforts, and as I aim to reveal, not the true root of the problem. The call for greater Transparency has been the safe and preferred battle cry within the capital market regulatory ranks for years. Unfortunately, greater transparency is completely meaningless to the plight of the equity market’s retail customers, without the proper infrastructure and policy to compliment. What use would a largely windowed store front and wonderful product display on main street be, if that window is not accompanied by a door for would be shoppers to enter and execute their wishes of buying those goods?
Whenever the pendulum of change makes it way into an industry, it often begins with a Robin Hood-esque cry for reform, attempted honorable cries for an effort to defend those with neither the voice, nor the power, to stand up for themselves and their rights. Usually the ground swell of reform centers itself around the ways with which to quell unjust practices, designing policy and governance to mitigate additional harm from occurring in the future. Unfortunately, in the case of the U.S. secondary Capital Markets, and specifically the policies of Regulation NMS, the root of current unjust practices lie in what seems to be unknowingly within the policies themselves.
This is the first in a series of articles I am authoring to help illustrate the dire need for policy reform concerning the current capital market structure under the rules of Regulation NMS. The explanations will be overly simplified as not to lose the exact audience in need of being informed, as is the case with so many inequities in business, the power to deceive lies within the jargon.
Beginning with the design and adoption of the Regulation National Market Structure rules in 2005 (Reg. NMS), the capital markets have since undergone a complete overhaul as to how, where, and how quickly trading is being executed. Within the broader scope of the Reg. NMS reform, there were certain policies I will later note, both specifically and even more alarmingly, are the exemptions [a] to these policies, which have led to the concerns I am speaking of today.
Regulation NMS made its first major impact with the introduction of “Payment For Order Flow”, which when paired with sub-penny pricing, is now directly responsible for birthing a new gold rush within the capital markets.
The dawn of the High Frequency Trading (HFT) community we witness today.
The result of this policy is an insurmountable, unequal, and unjust advantage for self-dealing BD’s and HFT’s, at the expense of the market’s retail level investors.
Payment for order flow as defined on the surface, can seem like a self-contained policy and practice, casually explained in short form by those wishing to keep the power of public opinion from identifying the practice as inequitable.
I would argue however, that payment for order flow as a legalized policy and practice, results in the complete and total destruction of opportunity for the retail investor to succeed in the marketplace. The practice is both inequitable and predatory. Moreover, when combined with certain rules and exemptions known on the street as the “Madoff Exemptions”, irreversible damage is being done on a daily basis to the industry’s reputation as a whole.
When we identify these contributing factors and their respective adverse effects, we can then begin to identify a proper regulatory solution.
To begin, it takes nothing more than a Google search and a few minutes of ones time to locate both the town hall, and comment and answer period transcripts surrounding the 2005 proposal of Regulation NMS.[b] While reading the transcripts regarding the architecture, design and proposed implementation of this newly proposed market structure and policy, you cannot help to notice the names of two primary advisors.
The now infamous Andrew and Bernie Madoff.
This simple fact should serve as concern number one, as many of the rules and now so-called “Madoff” exemptions, were designed to allow for and even incentivize, the same inequitable practices REG NMS set out to initially regulate.
Payment for order flow, as designed and created by Bernie Madoff, comes in two flavors. There are the maker/taker models that are now in effect in venues like the NYSE, which serve as the oxygen HFT firms need to breathe. The other variation comes in the form of payment for retail order flow by broker dealers, for the right to trade against such seemingly unsophisticated investors. This is where order flow internalization begins to show its true colors as prohibitive in upholding the best execution practices, which Regulation NMS originally aimed to uphold.
I would say it can be argued that this policy is responsible for spawning a new form of insider trading, as the purchasers of these orders then possess both an advanced, and privileged knowledge of the competition’s intent, which is then exploited for profit. Insider trading has previously been defined as using non-public information to gain advantage in anticipation of what the public might do once the information is released. How is it that now removing the need for any anticipation, and gaining that same advantage through the knowledge of instead the actual intent of the public in real-time, any less malicious and damaging?
As an industry tasked with conducting a fair and orderly market, originally designed to provide equal opportunity for all participants, herein currently lie massive failures, which need to be reassessed immediately.
With the SEC commenting recently that “The competition for order flow among these venues is intense, and it benefits investors by encouraging services that meet particular trading needs and by keeping trading fees low”[c], you can ask yourself, why is order flow the target of such fierce competition? Well the simple answer is that given the current rules, retail order flow is an all but a sure thing in regards to using it to turn a profit, a new gold rush of sorts.
This policy is solely responsible for allowing the purchasing broker dealer to commoditize a competitor’s investment intentions for their own benefit through the payment for retail order flow. When I speak of a retail investors sheer investment intent being commoditized, I mean to present the fact that the retail customer’s order is being left in the intention stage, as it is stepped ahead of before it is ever actually executed. This is why the potential damage being done is ultimately unquantifiable.
Payment for order flow, allows the professional trader (broker dealer), to purchase retail level order flow, for both the protection of their interests in the market and proprietary financial gain. The retail order is purchased both ahead of, and with prior knowledge to, the publicly displayed and protected customer order commitments, with which the investor originally intended to transact with. These intercepted orders are then executed simply to suit the proprietary interests of the purchasing broker dealer for their proprietary gain.
It is the ultimate display of middleman self-dealing, and it occurs without competition, in the sub-penny pricing universe, which needlessly exists within the fractions of a penny.
The beneficiaries of this practice will make their sole argument and have you believe they offer the intercepted order, “price betterment”. Are we to believe this argument that within the most unforgiving and highly competitive financial arenas, there are bands of good Samaritan broker dealers leaving money on the table for their competition out of the kindness of their hearts? Well to that argument I ask, what of the order on the opposite side of the execution? The customer was unable to obtain the execution he was entitled to prior to being stepped ahead of? The customer who’s opportunity to transact in the market and earn a potential profit was stripped away, what happens to that customer?
The answer simply is, nothing. This “price betterment” comes at exactly that customer’s expense, as his/her opportunity has now been stripped away.
In making that argument as a defense, broker dealers and HFT’s only prove to the world their sole motivation to purchase the stock at that moment was to step ahead of an existing order which was legally due a match against the order that has been “improved”. Even worse yet, this proves that the BD’s have the ability to unfairly control order flow in advance of it arriving at the matching engine and executed against competing investors. Did the investor who set the original intent to purchase the stock at a price receive the opportunity for a “second look” and alter his order to now pay within fractions of a penny to guarantee and receive his due execution? The answer is no. The negative ramifications of this practice are many, as we will soon uncover as we get further down the rabbit hole.
In his final year as SEC Chairman, Arthur Levitt vocalized an almost precognition and now validated warning as to the dangers of order flow internalization. [d] Under current Regulation NMS rules, the adverse effects Chairman Levitt feared, have not only been realized, but have manifested entirely new profit centers for a very small niche of opportunists, at the expense of many.
Payment for order flow is not a victimless crime, and the theft does not consist of a certain product or a price itself, but of the sheer opportunity. It is a heist of opportunity, of a fair chance to be in the competition, and of a level playing field with which the mere opportunity to buy and sell stock is available.
As it currently sits as a legalized practice, payment for order flow, results in the theft of the retail investor’s right to the simple opportunity to invest and participate in the market. This is a theft of opportunity. Which is exactly why the effects are impossible to quantify. The retail investor is left with two choices in the current market, pay the spread, or remain unexecuted. Passively bidding for or offering stock for sale is a dead end, the opportunity no longer exists.
When a company is experiencing margin compression… you first look to reduce costs of operating expenses, build out loss controls, etc… when costs can no longer be improved the only strategy you have to offset the effect of this loss of margin, is to drive higher volume. With execution costs already being as low as we have ever seen, the only way to drive revenue becomes through either an increase in volume traded for the BD’s, or for the sale of order flow on the brokerage side. This is why this lobby is so powerful, and the interest in keeping internalization here to stay is a battle at the highest levels.
Traditionally, volatility is what attracts traders to an issue, it is the air with which good traders need to breathe... add to that an increase in volume, and you have a recipe for success.
Volatility + Volume = OpportunityWhat payment for order flow does on an unequal playing field, is remove the need for volatility. The benefactors of the policy no longer need volatility and price movement in order to profit. For all intents and purposes, it creates a risk-less arbitrage.
Now the equation becomes:
Payment For Order Flow = Volume ( Volume unavailable to the open market )This NEW model now becomes
Volume - Volatility = Arbitrage ( Against retail order flow )The players in the space would conveniently like the public to believe the assertion that this “internalization” within the spread is what they like to define again as “price betterment.”
To illustrate, imagine you have a one stop light town we will call Main Street USA, and on this street, the town has proprietary businesses looking to buy and sell their respective products to earn their living. Knowing this, and knowing beforehand the exact prices the Main Street USA businesses are willing to pay for their products, a company we will call “Intertraders” sets up shop and opens its doors, right smack dab in the middle of the off ramp to Main Street, around the bend before the town comes into view. Armed with the Main Street USA product pricing and inventory in hand, “Intertraders” begins to offer the same number of products, for one hundredth of a penny less than Main Street, only right around that bend in the road. “Intertraders” also sets up a roadblock preventing any would be shoppers from ever reaching beyond them into the inventory of Main Street. In actuality when compared to what is allowed by Reg NMS payment for orderflow practices, "Intertraders" would be within the law to pull over any customers wishing to make their way to Main Street and sell them their goods, before and even against their will to transact on Main Street. It is a complete and total hijacking and retail investors are powerless to stop it.
Now before we start screaming definitions of Capitalism and a free market, what if we said that the local laws not only forbid the Main Street businesses to move their locations closer to the off ramp, but on top of that, passed a law restricting Main Street businesses pricing any products in penny increments? Even worse, the governing laws have not only allowed for a special set of exemptions, which allowed “Interbrokers” from conducting business this exact way, but furthermore placed barricades to keep Main Street from ever having the sheer opportunity to compete in the first place.
Again, the impact which internalization has upon our markets is unquantifiable, because it is the sheer restriction of opportunity, occurring under our very noses. Equal opportunity for all is not at work in the capital markets as it stands today, plain and simple.
So although these practices are theoretically allowable under current policy, I believe the people of Main Street would consider that an Unfair and Inequitable Business Practice. It would be even better if the Main Street business owners understood what was actually happening to them so they can attempt to advocate for themselves.
Payment for order flow is nothing more than the interception of retail customer orders through the exploitation of Reg. NMS exemptions, for the sole purpose of proprietary gains for a very select few, under the guise of “price betterment.”
Now given that scenario, being that all purchasing traffic is being diverted just before it ever arrives on Main Street, how long do you believe it will take before Main Street is out of business and boarded up…? How long does this need to go on before the powers that be start to realize the cause of the decline of participation and volume the markets have been witnessing the last 5-7 years? Retail customers are being turned upside down, shaken, disenfranchised and kicked to the curb, only wise to never return again.
Of all the current policies of Reg. NMS surrounding “Payment for order flow” which is disenfranchising retail investors on a massive scale, it is the allowance of sub-penny pricing which is the most inexcusable, injurious and discriminatory of policies.
The ability for broker dealers purchasing retail order flow to trade that flow completely unfettered within fractions of a penny, has resulted in the complete destruction of opportunity in the marketplace for the retail investor. It is impossible to make a single argument as to why this would be allowed to exist, other than the blatant exploitation of retail by the circumvention of the rules of parity, priority, and precedence. The simple practice itself is both rooted in and defined by, ceasing an opportunity to trade ahead and in front of, protected and displayed quotes.
During my time as an Exchange Official on the floor of the American Stock Exchange, 99% of all the disputes I made rulings in, concerned the issues of Priority, Parity, and Precedence. The market is designed to operate the same way a line works in a retail store, first come first served. Although it is a little more complicated, the PPP rules govern how stock is split between participants bidding or offering at the same price points during a sale.
Parity rules prior to Reg NMS governed how customers bidding/offering stock at the same price point would receive their due split of the sale. For example, in 2011 when SIRI (Sirius Sat. Radio) would literally trade hundreds of millions of shares within 2-3 cent range for months on end. A customer could wait all day to have his turn in the just to split among the thousands of customers trying to participate in the stock.
Now that you understand this, you should be able to understand that the entire purpose and design of sub-penny pricing, is to unfairly allow privileged broker dealers to essentially skip the line, avoid having to split the stock with the retail customers while essentially paying the same price… with the added benefit of being able to turn around and sell that exact stock to the retail customer as a built in insurance policy against losses.
This is fantastic if you are one of the lucky broker dealer firms to have such a great opportunity with which to quantify your risk against… but for retail, you are left unexecuted, again.
To illustrate:
Per the current rules, the tightest allowable published market in issues trading greater than 1.00, is one penny. The spread will then reflect this:
XYZ - 1.05 x 1.06Sub-penny pricing allows the Broker Dealers who are paying for the right to trade retail order flow, this opaque environment, with which to rob the market of equal opportunity. So even though the public is not privileged by the rules to see it, sub-penny pricing allows the market for Broker Dealers to be inside of the public:
XYZ – 1.0501 x 1.0599Just looking at the simple explanation above shines light upon the practice as predatory. Meaning that the only meaningful explanation for a Broker Dealer to transact order flow within the space of a penny, is to use this unfair ability afforded by the rules, to essentially front run publicly displayed orders. The result is the theft of the execution opportunity from the very customers putting capital at risk to publicly establish a liquid market in the first place. It also illustrates the reason behind the market’s volatile swings and dispels the misnomer that HFT adds liquidity to the market place. These operations do not operate and deploy capital unless there is existing liquidity to protect themselves and reverse out of positions with.
Although I would say without a shadow of a doubt that the retail investor is being damaged most by their execution opportunities being stolen, it is not the only concern. Sub-penny pricing also brings with it a distinct tactical disadvantage, and as I will later explain, a risk management equation so unfair, there is no other way to describe it other than being a rigged game.
In terms of the trading of equity, derivative, ETF, or listed option issues, the numerous factors influencing price movement and the resulting areas of resistance and support remain the same. When a resistance or support level has been established, be it by technical or psychological influences, or perhaps the simple presence of a displayed market inventory, opportunity for a trade will be abound.
Sub-penny pricing gives the Broker Dealer both a tactical and operational advantage with which to extract profit by exploiting the intentions of the competition. That advantage comes in many forms, but the most important and the easiest to explain would be regarding risk management.
Even the very best money managers, funds, traders, etc… have their days, or years for that matter, where the market just seems to have your number. It’s called being at the risk of the market, and very simply, no one is good enough to win all the time. Well at least that was the case prior to Reg NMS, and High Frequency Trading. In the last few years, the financial community is chock full with stories of HFT’s who have gone not only months, but years, without a single daily loss. How may you ask is such a monumental feat not only newly possible, but probable?
Well there are many ways this is now possible, including manipulation, order sniffing, co-location, payment for order flow, sub-penny pricing etc… but for the most part, this new market architecture was designed by the Madoff’s, so should we really be surprised? Hardly.
Good risk management begins with first identifying the factors contributing to your exposure that are within your control to positively influence, in turn decreasing the possibilities or severity of a loss. As they say in insurance, frequency breeds severity.
For example, you may not be able to control your genetics and predispositions to certain illnesses, but you do have complete control over decisions regarding your diet and exercise regimens in order to improve your chances of living a long and enjoyable life.
Point being, there has not been some watershed moment regarding risk management in the time since REG NMS implementation, seemingly allowing these BD and HFT operations to profit almost exclusively without risk. When reportedly going years and years without a single loss, you have to begin to wonder how this is all possible. It surely is not being contributed to some magical advance in actuarial science, it is being accomplished by controlling retail order flow, using it as both an insurance policy, and a revenue source
In a world of highly advanced and complex financial vehicles, sub-penny pricing and payment for order flow is allowing only those exempted few privy to its use, the most simple and risk free opportunity to scalp a profit.
For these simple few, there is no longer a need for extensive research and analyst departments, no need to synthetically hedge through expensive option contracts, or hardly even a true need to actually quantify risk… it is now as simple as locating someone who wants to buy or sell a stock, jump in front of them, use them for protection if things go awry, rinse and repeat. And the rules allow for this to happen, completely legally, all at the ultimate expense of the retail investor.
The way in which these records of previously unseen performance have been realized, is through working the orders being controlled, against the publicly displayed order flow, essentially making them an insurance policy with the use of sub-penny pricing. The status quo is to locate large displayed inventory, be it a heavily contested spread, a level of psychological or technical support or resistance, so on and so forth…
Such as:
3911 – 1.00 x 1.01 – 4580When a BD can intercept retail sell orders, and purchase the order by paying 1.001 ahead of the displayed 1.00 bids, the 1.00 bids become an insurance policy. The BD is protected, at very least by the close to 400K shares bid for, being that if the bid looks as if it is in danger of breaking down and the pressure builds, they can reverse the trade and flatten out their long position, hitting the 1.00 bid and realizing a .001 loss. This equates to $1000 dollar loss for every one million shares traded. On the flip side, for every one million shares that they are successfully able to execute within the one penny spread using sub-penny pricing, they will profit $10,000. Not a bad ROI when you conduct this operation day in and day out. The best part for the BD is that being able to profit in the stock doesn’t actually require a move in the stock price, or for them to ever actually take a risk and be correct in the upward movement. They can just continually operate within the spread, without competition, and with insurance against losses.
Also remember that the minimum profit that can be realized in the smallest spread allowable is .098, or just shy of .01 cent. That may not seem like a lot, but the opportunity itself is being bought for UP TO .0035. So the cost for the opportunity is roughly only 30% of the potential profit. There is no doubt that most, if not all, American businesses would only dream of a 70% profit margin.
Now to contrast that against the reality of what a retail investor faces. Let us illustrate against that same example.
3911 – 1.00 x 1.01 – 4580A retail investor who attempts to purchase the stock by bidding 1.00, will be intercepted and left unexecuted for as long as that trade seems stable, unless of course the BD needs to use them as protection, which will then result in an immediate loss as most likely the market will move downward. So in the event the retail investor wants to purchase the stock, he or she will need to pay the offering price of 1.01. Now as mentioned previously, this is an instant risk as the best bid available as insurance would be 1.00, a loss of .01 cent or 1%.
Being that sub-penny pricing and payment for order flow is for all intents and purposes, stealing the opportunity for the retail investor to obtain a passive execution on the bid or offer price, the retail investor will now need a displayed bid to hit to realize a profit. This means, that the market will need to move .03 cents or 3% in order for that retail investor to realize that same .01 penny profit the BD realized without a price move in the equity at all.
The stock will need to rise in this case 3% with the market moving from:
1.00 x 1.01To
1.01 x 1.02And finally
1.02 x 1.03Now that a 1.02 bid has been published on the NBBO, the retail investor who purchased stock at 1.01, can sell that stock at 1.02 and make their .01 cent profit. This is just a simple explanation of the headwinds and lack of opportunity retail investors have had legislated against them.
Simply put, market fragmentation = The Order Protection Rule killer.
In an attempt to guarantee the best price for investors, the order protection rule of REG. NMS mandated that exchanges aim to assure that all market participants receive the best possible displayed execution price available. Shortly after the rules were enacted, the decentralization of the capital markets and its now plethora of exchange venues effectively rendered the order protection rule 611 ineffective.
In theory the rule serves well, as many theories do, until they are put to the test of the real world. The simple fact is that the fragmentation of the capital markets with the addition of dozens new market venues, has not been met with the infrastructure and connectivity needed to enforce the new rules and adequately protect investors. Some of the connectivity roadblocks are indeed purposeful, obviously influenced by factors both political and financial, but nonetheless the cause is not the concern. It is the effect is has on execution quality, which is the most damaging to retail investors. In many cases this lack of connectivity between venues, is consistently causing a breach of fiduciary responsibility by brokerage houses to their clients.
For example, when you view a market montage in a listed issue, ETF, or derivative product, the top line consists of the best displayed market prices, and consolidated total inventory, which is known as the national best bid and best offer (NBBO). Under that best price, you will then see a montage with national exchanges and venues separately listed and their respective displayed inventory, which makes up the NBBO. This can all get quite complicated, with separate rules for access for Dark Pools, Retail, Direct Access etc… so for the sake of illustration, I will use a simple example and elaborate on the problem.
When a retail level investor wishes to enter the market and purchase stock through any number of the retail or online brokerage houses available today, the order you submit is executed in a number of ways. If for example you are an XYZ Brokerage customer, your order is firstly paired with any retail order flow on the opposite side of the trade, in-house, in order to maximize the commission billing to the brokerage.
If in the order is unable to be matched and executed in-house, it is then routed to the broker dealer who is currently paying XYZ Brokerage for the order flow. XYZ then routes the order to the second best venue pricing on the montage, which then again takes the same steps. In the event that there is still a lack of inventory to execute against within that second marketplace, the venue and house may publish the bid on the NBBO. Now while this has been going on, there may be offers with which your order can be executed to supply you with the price you desire, but those offers may reside in yet another one of the dozens of venues out there...
I will save the subject of what follows in the form of locked markets and the commission turf wars surrounding that for another time.
Even though your brokerage house has a fiduciary responsibility to make any and all attempts to secure the best price for orders entrusted to them, the waters become very muddy here, in that once they make that first attempt at shipping to the next best venue, the fiduciary responsibility to you is complete. The second venue is no longer burdened with best execution duties to you, as you are not a direct account holder with the second brokerage. I have seen this happen and I have seen this be quite catastrophic, with absolutely zero recourse as to a financial remedy to the victim.
The reason you may not be entitled to and receive the bid or offer price you are entitled to, which is by law, a firm quote once published, may be as simple an explanation as a lack of connectivity. Many firms, dark pools, exchanges and liquidity, simply do not allow anyone and everyone access to that liquidity. So if you are a retail client of XYZ, and there is a $2.00 dollar bid in ABC Exchange, and you would love to sell that buyer every share you own, you do not and will not ever have the ability to. The current unfortunate reality is, that the best price you are entitled to is limited to the best inventory your respective broker has on hand at that moment. No more, no less. Market fragmentation and the resulting order flow wars are systemically disenfranchising customers, which is exactly opposite of the original intent with which the order protection rules were designed.
I pose a simple question to end the discussion. There is a common belief on the street regarding retail order flow. It is believed by many that the value which is placed up retail order flow given the intense competition to purchase it by BD’s, is due to the simple fact that the poor, little, inexperienced retail customer is usually always wrong. Trading against an unsophisticated retail client with a professional’s superior skill, news dissemination, hardware and software, research, access to information, etc.. is regarded by many as a sure thing. So if the trading community is seemingly so confident in their inherent advantages, why then is there a need to foster an even greater disadvantage for the retail investor with the roadblocks and exemptions in our current policies?
There is a lasting and immeasurable ramification of these policies in that they are leaving the very people who finance the capital markets, the public, with a disdain and resentment for the industry. For every time the retail investor looks for an opportunity to participate in the market, he is turned upside down with pockets shaken out by an unfair and unjust set of regulations. Where the market should be thriving and growing clientele organically, and sustaining on repeat and lifelong clientele, we are witnessing the exact opposite… ever declining volumes and retail participation rates… the proof is there.
The retail investor is the most precious natural resource the financial markets has, we can no longer afford to let bad policy allow for the few to benefit at the cost of the many. Every time we attract a new investor who wishes to take part in the seemingly boundless opportunity the markets provide, but is in turn swallowed up and spit out by an unfair and rigged playing field, that resource is squandered. You cannot fail to make the association that the resulting immeasurable number of disenchanted investors are having on the market today. Participation rates are down, volume across the board has been in steady decline, and we are losing the very people who fuel the engine of this economy. I only hope to see equal opportunity for all once again in the greatest wealth creation vehicle the world has ever known.
John Marchisi
The original article used the term "decimalization" to describe "sub-penny pricing". Since decimalization is also a term used to describe Wall Street's switch in 2001 from pricing stocks in eighths and sixteenths (1/8 and 1/16) to pricing in pennies (decimals, 0.01), we changed (with the author's blessing) all instances of the word "decimalization" to "sub-penny pricing" so the reader wouldn't confuse the term's meaning.
Here are a few research pages we've published about sub-penny pricing: